Initial public offering

An initial public offering is a company selling shares to the public for the first time and joining a stock exchange. Afterwards anybody can buy a piece of it, and its price is published every second of every trading day.

Almost all of the work is invisible. For a year before anything is announced, accountants restate the numbers into the form a listed company must publish, lawyers write a document describing everything that could go wrong, and the board is rebuilt to look like the board of a public company. The roadshow everybody pictures is the last fortnight.

The selling itself works like this. A price range is published — say, twenty to twenty-four. Investors say how many shares they want and at what price. That list of orders is called the book. At the end, one price is chosen and everybody who gets shares pays it.

Here is the part that surprises people. The company chooses who gets shares, and the highest bidder does not automatically win. A fund that will hold for years is worth more to a company than one that will sell on the first morning, even if the second one bid more. Deciding who gets what is most of the skill.

Primary or secondary, and why it is the first question

If the company issues new shares, the money goes to the company and the existing owners are diluted. If existing shareholders sell, the money goes to them and nothing changes inside the business. Most listings are a mixture, and the split is disclosed. A large secondary component reads as owners reducing exposure, and investors price it that way.

The document

The prospectus is the transaction. Business description, risk factors, historical financial information, capitalisation, use of proceeds, the terms of the offer. The regulator reviews it and approves it — and approval means it discloses enough, never that the price is right. The playbook reads one in the order that works.

How the book is actually read

• Coverage — how many times over the deal is subscribed. Necessary and not sufficient.
• Quality — whether the large orders come from funds that hold or funds that flip.
• Price sensitivity — how much of the book survives at the top of the range. A book that is five times covered at the bottom and once at the top is a book that has priced the deal for you.
• Timing — orders that arrive on the first morning are worth more than orders that arrive when the deal is already known to be covered.

What happens after

• Stabilisation. One named bank may support the price for a defined period within published limits — see the greenshoe.
• The lock-up. Insiders agree not to sell for a period. The expiry is in the prospectus, it is dated, and the shares frequently weaken into it.
• Index inclusion, if the free float and other rules are met, which brings buyers who have no choice.

Underpricing: the largest cost, and the one nobody invoices

New listings typically price below where they trade shortly afterwards. That gap is not a fee and it is far bigger than the fee. On a deal where the shares rise thirty per cent in a week, the sellers handed thirty per cent of what they sold to the people who bought it.

Three explanations, all partly true and none complete:

• The winner's curse. Uninformed investors will only take part if the price compensates them for the chance that the informed ones knew to stay away.
• Information extraction. Investors reveal what they really think only if they are rewarded for it, and the reward is a price below their honest valuation.
• Aftermarket support. A deal that trades up attracts research, index buyers and a stable register. Issuers buy that with the discount.

Which is why "the deal traded up sharply" is not straightforwardly good news for the seller, and why an issuer that prices at the top of the range and trades flat has arguably had the better transaction.

Where the fee goes

The gross spread is a percentage of the money raised, deducted from proceeds. It is traditionally split between a management fee, an underwriting fee and a selling concession — the third being the largest, because placing the shares is the job being paid for. Increasingly a further slice is discretionary, awarded by the issuer afterwards, which pays for research and aftermarket support rather than for orders on the day.

Free float and who is obliged to buy

Index funds must hold what enters the index and may not hold what does not. Whether a listing qualifies — float size, domicile, share class, sometimes voting structure — decides whether a large, price-insensitive, permanent buyer exists at all. That is why float is negotiated rather than merely reported, and why dual-class structures are argued about so fiercely.

Why deals are pulled

• The window shuts: volatility rises and a book that would have filled does not.
• The range is refused — investors bid, below the bottom.
• The book is covered but of the wrong money, and the syndicate advises against pricing.
• Something surfaces that has to go in the document and cannot be resolved in time.

Pulling is a decision about the next attempt as well as this one, and issuers that pull and return later usually price lower than the range they refused.

The formulas above are standard textbook formulations, simplified for teaching. They explain the mechanism — they are not a valuation tool, and they will not reproduce a dealer’s price.